Any zoning reform or form-based codes or conferences about designing cities for people and not cars is for naught if there are no means to finance all of it. If banks will only lend money for office parks, shopping centers, and clusters of single-family homes around cul-de-sacs, that’s what will mostly be built, even in towns that know better.

It’s a problem that has plagued builders of small-scale, incremental development for many decades. In the most famous book on urbanism, The Death and Life of Great American Cities, Jane Jacobs wrote about how banks refused to lend mortgages to people with property in the North End of Boston, Back-of-the-Yards in Chicago, and East Harlem in New York because they had been designated as slums at one point.

“A merchant with whom I am acquainted in the blacklisted district of East Harlem in New York, unable to get a $15,000 loan for expanding and modernizing his successful business there, had no difficulty getting $30,000 to build a house on Long Island,” she wrote. Similarly, “Consider, for example, the case of a small New England city … with an extensive and well-publicized redevelopment program … the redevelopment staff prepared a map that showed where … clearance was deemed necessary. After the map was made, the planners discovered that it coincided, exactly, with the maps prepared by the city’s bankers many years previously designating localities into which no loans would be made,” apart from one neighborhood served by a small, independent bank that had continued making loans in the neighborhood.

These days, the obstacle preventing small development from being financed isn’t so much where a building is located as it is just getting a loan at an affordable rate.

Cary Westerbeck is a planner turned architect in a small town outside Seattle. After taking one of Jonathan Segal’s “Architect as Developer” courses and others through the Incremental Development Alliance, he decided to develop one of his designs, a three-story, mixed-use building, with a small commercial space on the ground floor and two apartments, including a residence for him and his family above.

“It’s crazy,” Westerbeck says. “This kind of building is all around the world. It’s the building block of cities.”

But he couldn’t find a bank that would touch it.

He talked to local, regional banks, who balked at providing a residential homeowner loan for building a commercial unit in it or a commercial loan for a building Westerbeck intended to occupy. One bank would have done it, if Westerbeck could have provided a personal guarantee of $350,000 from a backer. What was most confusing was that, with multiple income sources, such a building ought to be a safer choice than just a small apartment building or small commercial building.

In the end, much of the financing had to come from hard money at an interest rate of 12 percent, when a regular loan would have been nine percent. After a year, his broker was able to convert it into a 203(b) loan from the Federal Housing Administration, which Westerbeck described as a “vanilla residential loan … [but] it was the only loan we could get.”

That said, a 203(b) is a loan for purchasing or refinancing a primary residence that’s of one to four units, which still made construction a problem. The financing solution also made it impossible for the broker to sell on Wall Street because it’s so unique, it can’t be packaged with others. Another problem is that it’s a home-ownership loan, so Westerbeck would be unable to build another like it until the loan was paid off.

“When you’re not large, you fall through the cracks,” he says. “Every developer I talked to said to go to local, regional banks.”

What made the banks’ rejections more puzzling was that they came at a time when money was very cheap.

The refusal of banks to lend to Westerbeck might not be isolated. Johns Hopkins University did a study several years ago that found that even well-established businesses in Baltimore had difficulties getting credit from banks, explaining some of the persistent economic problems in the city. More recently, The Atlantic published an article by Robinson Meyer about how U.S. manufacturing businesses could not get loans, preventing them from growing or buying state-of-the-art equipment.

In a talk given at an Urban Land Institute conference in San Antonio (available on YouTube), Jim Heid, author of the book Building Small, said that big developers have capital stacks, while small ones have capital cocktails.

Westerbeck had no problem renting the building, either, even during the pandemic. He said that the commercial space was very attractive to several small businesses, ultimately ending up as a barber shop, because it was much smaller than other new retail spaces in town, and smaller businesses often don’t need as much space as larger ones.

Under the best of circumstances, financing real estate development can be complex. The aforementioned capital stack, according to Realty Mogul, consists of senior debt, which is secured and would get repaid first; mezzanine debt, which is when an investor gets someone to loan them some of the money they want to invest into a project, making a hybrid of debt and equity; preferred equity, which is equity that’s prioritized for repayment; and common equity, which is the equity that’s left.

The senior debt is the least risky and has the lowest return–that’s most of what banks would contribute. Mezzanine debt is more risky and offers a comparatively higher return. Preferred and common equity offer higher levels of risk. Assembling the money for a project, therefore, involves different sources with different repayment schedules and rates, as well as getting the right money at the right time. Purchasing a property to develop, for example, requires less cash on hand than hiring a contractor or worker to build the project.

Small developers, working on small projects, must further contend with various regulations intended to protect ordinary investors from being misled into taking on more risk than they can handle. Although the Securities and Exchange Commission’s accredited investors rules were recently loosened, the requirements still restrict investors to people with a net worth of more than $1 million (not considering their primary residence) or an income of $200,000 per year.

Federal Housing Administration rules are also very important in real estate financing. The FHA guarantees mortgages issued by the banks, removing a large part of the risk. The FHA made the 30-year fixed rate mortgage standard, for example. After World War II, it reinforced single-use zoning and encouraged building new homes in suburbs, instead of renovating existing homes in cities. According to Charlie Gardner, the FHA also used their mortgage guaranteeing powers to review subdivision plans, and thereby encouraged developers to build far wider streets than were needed.

As Jonathan Coppage put it in an op-ed for the R Street Institute, “The Federal Housing Administration has to re-legalize Main Street.” According to Coppage, “To this day, FHA standards for loans, which set the market for the entire private banking sector, prohibit any but the most minimal commercial property from being included in residential development … Without the FHA’s blessing, projects are granted the ‘nonconforming’ kiss of death unless their developers can persuade a local bank to write an entirely customized loan for them, one whose risk the bank would have to keep entirely on its own books.”

Some loans would only allow mixed-use buildings if they reached 17 stories. According to the Regional Plan Association, commercial floor space or income is capped at 15 to 25 percent of multi-family developments, which translates into six-story buildings. Federal rules also mean that commercial rents are mostly ignored by lenders. The result is that mixed-use buildings are harder and more expensive to develop for the big developers, much less so than the small ones.

Meanwhile, if personal relationships are the key to getting banks to write these custom loans, the ongoing consolidation of the banking industry is a worrying trend, as the decision-making power will be removed further and further away from the local branch. Strong towns need strong local banks to keep capital in the region–not just for building homes, but for funding small businesses and even buying municipal bonds. Unfortunately, common alternatives to banks, such as credit unions, are prohibited from many commercial transactions, while the Institute for Local Self-Reliance reports that the number of new banks starting up has fallen to nearly nothing since 2009, even as consolidation has continued. They believe that low interest rates, which reduce revenues for traditional banking activities, are part of the problem, as well as federal regulations that require new banks to be more capitalized and supervised for longer.

Between 2008 and 2015, nearly 2,000 local banks disappeared, mostly by mergers or acquisitions. By 2018, the four biggest banks in the country–Wells Fargo, Bank of America, JP Morgan Chase, and Citigroup–had 36 percent of the bank market share, while other large banks had a further 23 percent. As recently as 1995, the biggest banks had only a 16 percent market share.

Small developers may be at a disadvantage compared to their larger counterparts, but in the era before the FHA, credit wasn’t always easy to come by. Incremental development is in part an adaption to a lack of easy money–you built what you could afford to build and then added to it over time. This kind of thing was still being done in Mexico as recently as the 2010s, according to Charlie Gardner.

Still, there’s no denying the convenience of loans or the importance of banks in harnessing a community’s wealth to accomplish things. The decline of local banks and the subsequent difficulties in writing custom loans for local small developers not only prevents the community from investing in itself, but it may help encourage officials to court big projects. Many cities, for example, have programs where they seize abandoned properties, demolish the decayed structures, and assemble the small land parcels into large parcels of a half-block or bigger, all ostensibly to make redevelopment easier. A side effect is that the neighborhood loses all its remaining small businesses, because there are no longer any properties small enough for them to afford.

In a financial startup world of mobile payments and cryptocurrency, there must be some room for strong banks serving strong towns.